AP Macroeconomics The Money Market

The market where the Fed and the users of money interact thus determining the short- term nominal interest rate (i%). Money Demand (MD) comes from households, firms, government and the foreign sector. The Money Supply (MS) is determined only by the Federal Reserve.

Money Demand Transaction Demand – demand for money as a medium of exchange (independent of the interest rate). Asset Demand – demand for money as a store of value (dependent on the interest rate). Total Money Demand – (MD) is downward sloping because at high interest rates people are less inclined to hold money and more inclined to hold stocks & bonds. At lower interest rates people sacrifice less when they hold money.

Money Supply The money supply is determined by the Federal Reserve because the Fed has monopoly control over the supply of money.

The Money Market The equilibrium of MS & MD determines the nominal interest rate (i%). MD is downward sloping because the nominal interest rate is the opportunity cost of holding money. MS is vertical because it is independent of the interest rate. i% i QMQM MS MD Q

Changes in Money Demand Money Demand is dependent on both the Price Level and Real GDP which together comprise the Nominal GDP – Nominal GDP↑.: MD .: i%↑ – Nominal GDP↓.: MD .: i%↓

Increase in Money Demand MD .: i%↑ i% i QMQM MS MD Q i1i1 MD 1   

Decrease in Money Demand MD .: i%↓ i% i QMQM MS MD Q i1i1 MD 1   

Changes in the Money Supply Only the Fed determines the money supply Expansionary Monetary Policy – MS .: i%↓ Contractionary Monetary Policy – MS .: i%↑

Increase in Money Supply MS .: i%↓ i% i QMQM MS MD Q i1i1 MS 1    Q1Q1

Decrease in Money Supply MS .: i%↑ i% i QMQM MS MD Q i1i1 MS 1    Q1Q1

12 Money Supply Terms M1= Checkable Deposits and Currency M2= M1 + Savings deposits, money market accounts, small time deposits (less than $100,000) M3= M2 + time deposits over 100k. Velocity of Money Equation: – MV = PQ ( GDP) (M= Money Supply and V = Velocity (number of times per year the average dollar is spent on goods and services. – Argument against FED action. Increase in MS = PL increase

13 Banks and Balance Sheets AssetsLiabilities Reserves$15,000Checkable Deposits$100,000 Securities$15,000 Loans$70,000 If the current reserve requirement is 10%: 1. What is the amount of new loans this bank can generate? Answer: $100,000 Checkable deposits X a 10% reserve requirement = $10,000 required reserves. If the bank has $15,000 in reserves, $5,000 of those are excess reserves and can be loaned out. 2. How much in new loans can be generated by the entire banking system? Answer: Money Multiplier = 1/Required Reserve Ratio=1/ X $5,000 = $50,000